2nd Quarter Client Note

The coining of a new phrase – “taper tantrum” – spiced up a volatile second quarter. Reacting swiftly to Federal Reserve Chairman Ben Bernanke’s late June announcement that there was some evidence of improvement in the economy and a possible change in the Fed’s accommodative monetary policy, skittish investors precipitously sold both stocks (from May’s record highs) as well as bonds. Just another example of “good news is bad news” in the topsy-turvy world of the investment markets.

Through the Looking Glass

This quarter demonstrated an unusual kind of Alice in Wonderland performance in which stocks gained and bonds suffered significant losses. But despite the June sell-off, the S & P Total Return Index (including dividends) gained 2.91% for the quarter and 13.82% for the first half. International markets, on the other hand, were negative. The MSCI EAFE Developed Markets Index was down .98% and the Emerging Markets Index was down 9.14%

The yield on the benchmark 10 year Treasury bond rose from 1.87% to 2.5%, a level not seen since August 2011. Consequently (reflecting the inverse relationship between interest rates and bond prices) the Barclays US Aggregate Bond Index fell 2.44% –  the largest quarterly loss in nine years. An even bigger casualty in fixed income was TIPS (Treasury Inflation Protected Securities) – which lost 6.61%. TIPS tend to have high interest rate sensitivity (duration.) But inflation remains tame at around 1%.  When interest rate increases are not accompanied by increases in inflation for which they are designed, TIPS are disproportionally affected.

No Bottomless Punch Bowl

In his June 19 news conference, following the board’s two-day policy meeting, Chairman Bernanke indicated he expected unemployment to fall from 7.6% to 7% over the course of the next year – at least arguably signaling an end to QE 3, the Federal Reserve’s massive bond purchasing program designed to keep the economy from slipping back into recession.  Although he was not exactly clear when.

Fed policy has kept short term interest rates at near zero and the ten year rate at less than 2% for nearly five years. Low interest rates have clearly been good for Wall Street traders, who borrow at historically low rates to invest in higher yielding securities. But this has been terrible for Main Street savers and investors who need a reasonable place to invest the safe portion of their retirement savings. Historically, the yield on the 10 year Treasury bond has averaged 2.45% above inflation. With inflation running at 1-2% the 10 year bond should be yielding between 3.5% and 4.5%.

Preparing for the Inevitable

Interest rates will inevitably rise toward – and perhaps beyond – their historical average. But it is impossible to know when or how quickly. The economy may not grow as quickly as we would like. And Chairman Bernanke has indicated that even when the Fed does begin to reverse course, it will look more like a driver easing off the gas rather than slamming on the brakes.

In any event, the most important consideration is to know why you are invested in bonds. For most investors the reason is to reduce risk. Even in a rising rate environment, bonds are a far less volatile asset class than stocks. Investing a portion of a portfolio in short term, high quality bonds is a tried and true method for managing overall portfolio risk. Such a strategy occasionally carries the necessity of suffering through a bout of short term pain. But as interest rates rise, reinvestment will occur at higher rates, resulting in higher future expected returns. And while bond returns over the next decade will be nowhere near those over the past decade (annualized return on the Barclays US Aggregate Index was 5.9% from 2003 to 2012) the expected return for bonds is certainly higher than it was before the rate rise.

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